Investors face ESG correction as risk mispriced, study shows

Investors lack financial incentives to chase sustainable targets, leaving them more exposed to losses once sentiment shifts, according to a study by academics at the University of Cambridge.

Despite years devoted to trying to make environmental and social investing financially appealing, there still aren’t enough structures to encourage banks and asset managers to allocate capital in ways that will ultimately protect the planet and its inhabitants, scholars at the Centre for Sustainable Finance at the University of Cambridge Institute for Sustainability Leadership (CISL) wrote in a study published on Tuesday.

Read: Buyer’s remorse hits finance bosses who ‘overhired’ for ESG

“Currently, the financial system isn’t incentivised to consider sustainability in financial decision-making,” Nina Seega, director at CISL, and Eliot Whittington, the group’s chief systems change officer, said in the report. They cite an absence of capital charges on unsustainable activities and no incentive to exit at-risk assets. Meanwhile, capital allocations in activities that hurt the environment “make more money than sustainable activities,” they wrote.

The upshot is markets have failed to provide adequate pricing signals for the real risks that lie ahead, according to the academics.

There’s “an assumption that market players will all be able to exit at once if market sentiment shifts,” they wrote. But “multiple financial crises taught us [this] isn’t the case.”

The warning comes as sustainable principles such as ESG (environmental, social and governance) and DEI (diversity, equity and inclusion) are increasingly vilified in the US, as the Republican Party seeks to root out what it’s dubbed “woke” capitalism. Such attacks have held up the lack of financial returns on ESG investments as proof the strategy ignores fiduciary interests.

ESG, which enjoyed a brief boom during the pandemic, has struggled to right itself as higher interest rates and supply-chain bottlenecks have hampered the progress of capital-intensive green infrastructure. As a result, the theme has rapidly lost investors, with Morningstar Inc. noting in April that ESG funds suffered their worst outflows on record in the first quarter.

Anti-ESG sentiment has swelled as the world looks set to blast through the critical threshold of 1.5C of warming. The real-world fallout of that trajectory is already surfacing in the insurance industry, with Swiss Re Institute recently warning that this year may bring $145 billion of insured losses, which is well above the 10-year average.

What Bloomberg Intelligence says…

Extreme heat tied to climate change is forcing a wide swath of industries to respond and adapt. Without adjustments, heat-related labour-productivity losses could tally $500 billion by 2050, according to an Arsht Rockefeller study, with agriculture and construction particularly exposed. Tourism is seeing a shift in seasonality, as is the apparel industry. Even data centres are at risk.

There’s a “substantial risk” of disruptive market repricing once sentiment shifts to reflect the physical reality of climate change, according to the authors of the CISL report. At the same time, investors who take climate change into account are opening the door to a $10.3 trillion opportunity in the new green economy, they said.

“Finance needs to change not only to avoid a substantial risk of a disruptive market repricing once the sentiment shifts to reflect physical reality, but also to benefit from the multitude of opportunities that such a transition brings,” they said.

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